Wednesday, May 1, 2024

A big myth in credit card and loan repayment is to “start with the smallest debt” and work your way to the largest.

I have been asked repeatedly about this debt-repayment strategy during radio interviews and directly, and the only reason that I can think of that some people may pay the smallest debts first is purely for psychological reasons. They want to feel like they’re wiping out their debt, and it may seem faster to start with the smallest debt. But the reality is that it may take longer.

The advice that one should “start with the smallest debt” when applying payments should never be used as a rule of thumb. Paying the smallest debt first is only good when the smallest debt happens to be the debt with the highest interest rate. If that’s not the case, then paying the smallest debt first can be a costly mistake.

The least expensive way to apply payments to your debt is to pay the most toward the highest-interest-rate loans (that’s the rule). Here’s an example that illustrates exactly what’s going on: 

Say you have two debts: $11,000 at 18% APR with a minimum monthly payment of $220, and another loan of $7,000 at 6.9% APR with a minimum payment of $140. You also have a total of $500 per month available to pay toward both loans, and you want to apply the payments in the most efficient way to each debt. 

Strategy 1: Pay the smallest debt first.

The most you can allocate to pay toward the “smallest debt” is $280, because you must make minimum payments of $220 on the larger debt ($280+$220=$500). If you make the payments in those amounts, the “smallest debt” ($7,000) is paid off in 27.07 months. During this time, you are paying $220 toward the $11,000 debt, which will now have a balance of $9,180. 

Since the “smallest debt” is paid back, you can put the total $500 toward the remaining debt. And with that payment, it takes 21.64 months to finish repaying it. The total time you’re making payments is simply 27.07+21.64=48.71 months. Each of those monthly payments totals $500, so the total amount to repay the original debt of $18,000 is $24,355 (48.71 months x $500).

Strategy 2: Pay the highest interest rate first.

It would be nice if you could use the total $500 and pay it toward the 18% debt, but you still must make minimum payments on the other loan. So the payment structure begins with $360 being paid toward the $11,000 debt and $140 toward the $7,000 debt. Notice that the total payments are still $500. 

With these payments, the $11,000 debt is paid back in 41.18 months, and the remaining balance on the 6.9% loan after this time is $2,380. Now that the high-rate debt is repaid, you use the total $500 toward the remaining debt, which is then completely paid back in another 4.84 months. The total repayment time is 41.18+4.84=46.02 months and the total monthly payment is still $500 for each of those months, bringing the grand total of paying back the loans to $23,010 (46.02 months x $500).

Conclusion

The bottom line is that the pay-the-smallest-debt-first strategy cost $24,355 to repay the original debt, and the pay-the-highest-interest-rate-first strategy cost $23,010 in total payments. By applying the payments toward the highest interest rate first, the amount saved is $24,355-23,010=$1,345! What a difference the payment order can make—that’s a HUGE chunk of money! You could buy an entire, top-of-the-line, multimedia Pentium computer system with that, or 270 McDonald’s value meals. The best part of the strategy is that you’re paying the same amount per month and using the same checks and stamps; the only change is how much you apply toward each loan. 

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